Xavier Gine, DECRGXavier Gine, DECRG

AADAPT WorkshopGoa, Dec 17-21 2009

Rural Finance: What have we learned?Rural Finance: What have we learned?

• Credit– Overview– Case Study: DrumNet in Kenya

• (Savings)

• Insurance– Overview– Case Study: Rainfall Insurance in AP, India

Overview of Financial ServicesOverview of Financial ServicesOverview of Financial ServicesOverview of Financial Services

Credit: OverviewCredit: OverviewCredit: OverviewCredit: Overview

Percentage of households that have at least one loan with…

0102030405060708090

All Marginal Farmers Small Farmers Large Farmers

%

PACS SHG Formal Institutions Informal Source

• Data from a stratified random sample of PACS and non-PACS farming borrowers in AP.

• Informal lenders are the most use source of credit for all

Loan CharacteristicsLoan Characteristics

• Loans from PACS are the most attractive in terms of maturity and interest rates.

• However, they require collateral (also formal sources) and are typically very small.

PACS SHG Formal Sources Informal Sources

Number of Loans since April 06 861 175 454 1,051

Median Borrowed Amount 10,000.00 7,000.00 20,000.00 20,000.00Mean Borrowed Amount 15,734.30 8,725.14 44,564.98 26,522.36Std Borrowed Amount 29,993.24 6,871.54 141,475.30 40,678.09

Maturity (Months) 24.32 14.80 15.55 17.11Annual Interest Rate (%) 16.85 19.07 20.10 31.71Pct. of loans that equire Physical Collateral (%) 98.14 4.00 91.41 8.09

Loan Characteristics

Formal Sources includes Basix / Bartiya Samruddi / KBS Bank or NGO, commercial banks, rural bank andgovernment bank. Informal Sources refers to friend/relative, local money lender, landlord/employer, local grocerystore, pawn broker and others. Physical Collateral includes land, house, gold, crops or livestock (the rest of loansrequired guarantor, fund-savings or other collaterals).

PACS recovery rates

010203040506070

[0,25] (25,50] (50,75] (75,100]

Percentage

%

Anantapur Vizianagaram Mahbubnagar

PACS repayment based on Special PACS repayment based on Special ReportReport

• Pressure to forgive debts in bad times or to win political favors. – Relief measures respond more to elections than to rainfall.

• As a result, credibility and hence sustainability is jeopardized as farmers will wait to repay until the government announces a relief package. Given soft stance on repayment, PACS are the last lender to be repaid.

Government CreditGovernment Credit

Why are informal interest rates so high?Why are informal interest rates so high?

• Simplest case: R=120% (or 10% per month)• Assume a risk-free rate of 10%, probability of

default must be 50% to justify a 120% interest rate under competitive markets if no other costs are involved.

• But default rates are typically much lower than 50%– Singh (1968) in India

• 1 of 45 transactions, lender lost all the principle and in 29 of these part of the interest not recovered, so default explained 23-43 percentage points of the overall interest rate charged.

– Aleem (1980) in Pakistan• The default rate was less than 2% for the median lender and

10% for the maximum.

• Aleem also collected detailed information on moneylenders exact monitoring and screening activities, and the costs of such activities.

• The direct cost of lending is almost 50 paisa to the rupee, explaining the gap between deposit and lending interest rates.

Why are informal interest rates so high?Why are informal interest rates so high?Why are informal interest rates so high?Why are informal interest rates so high?

• So rural credit markets are characterized by high lending costs driven by difficulties in screening, monitoring and enforcing

– Screening: Determining who is creditworthy– Monitoring: Observing ability to repay a loan (and hence

who to collect against)– Enforcing: Collecting the money

• In the past 30 years, however, we have witnessed a flurry of innovations, all in some way designed to reduce the cost of lending to the poor

Rural CreditRural Credit

• Two ways to reduce lending costs:

– Improve the borrower’s incentives, • Threat of future credit denial, escalating loan amounts

– Shift key responsibilities from lender to client• Delegate screening, monitoring and/or enforcing to

client

The Microfinance PromiseThe Microfinance Promise

• Group liability: Clients are liable for each other loans.

• Group lending: Public repayments, bank comes to villages

• Flexible collateral• Repeat lending (with increasing loan size)• Focus on women• Regular (weekly, monthly, etc.) repayment schedule• Credit with Education• Mandatory savings

• Kept by Lender, or available to the group to re-lend out to themselves or others, as an internal investment fund

Key Innovations Key Innovations

• Harness innovations in financial contracts and institutions to overcome market failures

• Help attain development goals more cost-effectively than other measures

• Help poor and low-income households take advantage of economic growth

• Cover all costs through fees and expand without constraint, ultimately integrating with the commercial finance sector.

The Microfinance PromiseThe Microfinance Promise

• Adjusted Financial Information on 124 institutions in 49 countries 1999-2002

• Selected sample since institutions share a commitment to financial sustainability and transparency

• 3 Types of Institutions: – Individual-based lenders, – Solidarity group lenders, – Village Banks

The MIX DataThe MIX Data

Financial performanceFinancial performance

Lending mode:

IndividualsSolidarity Groups

Village Banks

Financial self-sufficiency

111% 98 95

Operational self-sufficiency 123% 112 109

Subsidy 11% 28 36

Return on assets 1% -5 -8

Age (years) 11 years 9 7

Lending mode: Indivi-duals

Solidarity Groups

Village Banks

Average loan size ($)

1220 431 149

Avg loan size/GNP of bottom 20%

4.8 1.6 0.6

% women 46% 75 88

Size rank 2.2 2 1.6

Outreach IndicatorsOutreach Indicators

• What are the barriers to the adoption of new technologies faced by small landholders?

– Lack of capital – Lack of infrastructure to market– Missing information about profitability or how to

adopt them– Inherent riskiness of technology itself

Case Study: DrumNetCase Study: DrumNet

• What are the barriers to the adoption of new technologies faced by small landholders?

– Lack of capital – Lack of infrastructure to market– Missing information about profitability or how to

adopt them– Inherent riskiness of technology itself

Case Study: DrumNet in KenyaCase Study: DrumNet in Kenya

• In the region we study in Kenya,– Access to capital is limited because

• Banks and MFIs have tried crop financing and farm input loans but have generally failed.

• Exporters have tried extension services and out-grower credit schemes with mixed results.

• Small-scale agro-supply vendors sell seeds and agro-chemicals on credit but have limited penetration.

– Road infrastructure is poor and smallholder farmers have deficient means of transportation

– Trust issues with buyers in Nairobi

MotivationMotivation

• Conduct a field experiment with DrumNet, a for-profit Kenyan NGO, to examine whether a package of extension, credit and marketing services helps farmers (organized in Self Help Groups) adopt, finance and market export crops.

• Observe take-up• Measure impact

Intervention Intervention

• DrumNet is an NGO that encourages the production of an export oriented crop through a cashless micro-credit program by linking directly commercial banks, smallholder farmers, retail providers and exporters.

• Solves trust problems found in contract farming.

DrumNet programDrumNet program

• A farmer that wants to be a member of DrumNet has to:– Be a member of a registered SHG.– Express an interest export crop French beans.– Have irrigated land.

• Upon registration, DrumNet members – Receive a 4 week orientation on Good Agricultural

Practices and EUREPGAP requirements.– Open a personal savings account with local bank.– Make a cash contribution of USD 10 that will serve as

collateral for a line of credit of up to 4 times that amount to purchase inputs (seeds and fertilizer).

DrumNet programDrumNet program

• Farmers are organized into groups of 5 who are jointly liable for the loans taken out.

• At harvest time, DrumNet negotiates a price with the exporter and arranges for the produce pick-up at pre-specified collection points.

• A transaction agent is appointed in each collection point to serve as liaison between DrumNet and the farmers.

• At these collection points, farmers grade their produce and package it, although exporter has the final word on the grading.

• Once the produce is delivered to the exporter, the exporter pays DrumNet who in turn deducts any loan repayment and credits the rest to the member bank account.

DrumNet programDrumNet program

Location• Gichugu division in the Kirinyaga district. It was chosen because

of its agro-climatic conditions (similar to original DN locations) and because the clustering of participants was feasible logistically.

Sample Framework• Original sample of 96 registered SHGs including disbanded

groups. Run a “filter” survey to find out the status.• Final sample of 36 SHG whose combined number of members

reached the target DrumNet capacity of 750 individuals (20-40 members in a group).

Randomization of SHGs • 12 got all services except for credit• 12 got all services including credit• 12 Control

– All analysis will cluster standard errors within SHG

Experimental DesignExperimental Design

Experimental DesignExperimental Design

• Among individual determinants,- Literacy, being a SHG officer, household size and

having irrigated land predict participation.

• All in all, participants are not the wealthier farmers nor those that use the most efficient production techniques.

- They face sever constraints (marketing) and that hope DN will mitigate them.

Take-upTake-up

• DrumNet led to an increase in cultivation of cash crops, increased usage of financial services and reduction in overall marketing costs.

• These gains translate into a significant increase in overall income for first-time growers but not for everyone.

• No detectable gain from credit alone.

Impact after one yearImpact after one year

• One year after the introduction of EurepGap requirements, exporters refused to purchase the produce since none of the SHGs were certified.

• This resulted in DrumNet’s collapse and angry farmers reverting back to growing crops for local markets.

• Bitter irony: Trust was a big motivation for DrumNet’s creation.

EpilogueEpilogue

• Innovative product that can improve welfare of the poor by enhancing consumption smoothing and therefore encouraging technology adoption.

• Key benefits: – No adverse selection (except maybe temporal), – No moral hazard– Easy to price, provided data is available– Easy to purchase (private company, not government)– Fast claim settlement

Index-Based InsuranceIndex-Based Insurance

rainfall during phase

payout for phase

1st trigger(100mm)

2nd trigger[corresponds to crop failure]

(40mm)

(900Rs)

(2000Rs)

Insurance splits monsoon into three phases:(i)Sowing(ii)Podding / flowering(iii)Harvest

Payouts in each phase based on cumulative rainfall in the phase (each is 35-45 days)

Insurance Design (Narayanpet)Insurance Design (Narayanpet)

• Although government crop insurance has been available for some time, it is mostly compulsory – As a result, most borrowers remain uninformed as they perceive

the premium is as a fee.

• Thus, the provision of explicit market-based rainfall insurance to Indian households remains a new and relatively untested concept.

• While in some cases financial contracts to hedge risk do not exist, when they do exist, their use is not widespread.

Uptake of Index-Based InsuranceUptake of Index-Based Insurance

Year

Number of villages where insurance is

sold

Total number

of contracts

Contracts per village

2003 17 194 11.4

2004 43 318 7.4

2005 422 3214 7.6

2006 538 6039 11.2

32

Rainfall Insurance PurchasesRainfall Insurance Purchases

1. We got it all wrong, and households do not need formal insurance.• Government relief may crowd-out insurance.

Banks may provide implicit insurance if defaulting loans are restructured

• In general, households use several ex-ante and ex-post mechanisms to smooth consumption and labor

• But there is some evidence suggesting that these are:• Insufficient, especially for poor households.• Costly, in the sense that they trade-off risk for lower

return• Imperfect if shocks are correlated

Why???Why???

2. Households do not want insurance.• Afraid of crowding-out of informal

arrangements• Poor assessment of probabilities (Kunreuther)• Basis risk

3. Households do not understand insurance product

4. Households do not trust insurance provider5. Households do not have cash / liquidity to

pay for insurance

Why???Why???

Products can be specifically designed to address the different barriers, but there are tradeoffs.

1. Voluntary or Compulsory• If cognitive failure matters, make it compulsory,

but farmers may not use it as hedging instrument

2. Frequency of Payouts– Low Frequency (catastrophic) vs High

Frequency• If trust matters, perhaps high frequency in the

initial stages.

Design IssuesDesign Issues

1. Linked to credit?• Stand-alone or bundled

4. Information• Who should provide it? How much? How?

5. Amount of Coverage?6. Type of beneficiary

• Household• Financial Institution

• Crowding-in

7. Subsidies?

Design IssuesDesign Issues